The U.S. Midstream Sector in Transition: Outlook and Implications

1
The U.S. Midstream Sector in Transition
Outlook and Implications

• Presented to The Canadian Institutes
• 6th Annual Conference Midstream 2003
• November 25, 2003

Peter Fasullo EnVantage, Inc. Houston,
Texas www.envantageinc.com
2
The U.S. Midstream Sector Is Undergoing a
Transformation

• Fundamental changes - upstream and downstream.
• Excess capacity across most of the Sectors value
  chain.
• Independents struggling to reduce margin
  volatility.
• Tight credit hampering many Diversified Energy
  companies.
• Major Integrated Oils reassessing if Midstream is
  core.
• Assets being sold and new players entering the
  sector.

• Independents Midstream Companies who primarily
  serve 3rd Parties

3
Major Questions

• Can U.S. Independent Midstream entities prosper?
• How will relationships change between Midstream
  players and their customers, upstream and
  downstream?
• What will be the factors for success?
• Will a new and improved business model emerge for
  the U.S. Midstream Sector?
• Will changes in the U.S. impact the Canadian
  Midstream Sector and how?

4
Topics to Be Covered

• Broad Overview of the U.S. Midstream Sector
• Structural History Evolution
• Current Players and Their Strategic Positions
• Major Issues Challenges
• Factors for Success
• Ideal Business Model and Future Ownership
• Implications for the Canadian Midstream Sector

5
U.S. Midstream Sector Broad Overview
6
Simple Definition
The Midstream Sector is a collection of assets
services that help bridge the supply side of the
value chain with the demand side for any type of
energy commodity. As such The Midstream Sector
is only as strong as the linkages it has with
energy producers and end users.
Midstream
7
Typically U.S. Midstream Functions Are Considered
Deregulated Assets, Such As

• Gas Gathering, Treating Processing
• Gas Pipelines (Primarily Intrastate)
• Product Pipelines
• Fractionation
• Gas Product Storage
• Inland Product Terminals
• Import/Export Facilities

Presentation focuses mainly on the gathering,
processing and downstream NGL functions.
8
The Midstream Sector Is Where the EP, Gas,
Refining and Petrochemical Industries Intersect
Downstream
Midstream
Petrochemicals
Fractionation
Upstream
Refining
Exploration Production
Processing Treating
Propane Retailing
NGL Transportation
NGL Storage
Gathering
Gas Retailing
Gas Distribution
Gas Transportation
Gas Storage
Subject to challenges outside of its control
Power Retailing
Power Distribution
Independent Power Generation
There are no distinct ownership borders
9
Specific Transportation Corridors Link Major
Processing Regions to NGL Market Centers
Edmonton/ Ft. Saskatchewan

WCSB
NGL Flow Diagram
Sarnia

Rocky Mountains
Conway


Anadarko
San Juan

Major Processing Regions
Arkhoma

River
Permian
NGL Market Centers (Storage, Fractionation,
Pipelines)

Gulf Coast Offshore
Mt. Belvieu

South Texas
NGL Product Flows
10
U.S. NGL Midstream Industry Highlights

• U.S. Midstream/NGL sector is a 15 to 20 billion
  a year business, but pales in comparison to Power
  Gas
• Electricity 200 billion/year plus
• Gas Transportation 50 billion/year plus
• NGL Transportation/Fractionation 3 to 5
  billion/year
• Total U.S. NGL supplies (production and imports)
  are slightly below 3 million barrels per day
  (bpd)
• Gas Processing -- 1.90 million bpd (68 market
  share)
• (Product Mix Ethane 37, Propane 29, Butanes
  18, N. Gaso 16)
• Refinery Production -- 0.68 million bpd (24
  market share)
• Imports -- 0.23 million bpd (8 market share)

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NGL Midstream Industry Highlights (Cont.)

• US NGL production from processing distributed
  within the major hydrocarbon basins in the
  country
• Gulf Coast --- 24.
• W.Texas/ Rocky Mtn. --- 53.
• Mid-Continent --- 13.
• Other --- 10.
• Majority of NGLs consumed along the Gulf Coast
• Petrochemicals -- 56 of total NGL demand 92
  along G.C.
• Gasoline Production -- 15 of total NGL demand
  45 along G.C.
• Fuel Uses -- 29 of total NGL demand SE,
  Mid-Cont., NE.

• 590 processing plants - 72 BCFD cap.
• 56 of plant capacity is cryogenic
• 70 fractionators - 2.0 million BPD cap.
• 85 of frac capacity is centralized at
• market centers

12
U.S. NGL Prices Are Set in Competition With Other
Hydrocarbon Products in the Market
NGL Primary Market(s) Competing Products Secondary Market(s) Competing Products Supply Regions
Ethane Ethylene Propane N-Butane Naphtha Gas Oils Retained in Natural Gas Residual Fuel No 2 Fuel Oil Propane North America
Propane Ethylene Ethane N-Butane Naphtha Gas Oils Space Heating Natural Gas No 2 Fuel Oil Global
N-Butane Gasoline I-Butane Other Gasoline Blendstocks Ethylene Other Ethylene Feedstocks Global
I-Butane Alkylate MTBE Other Gasoline Blendstocks Petrochemicals Global
Natural Gasoline Gasoline Other Gasoline Blendstocks Ethylene Other Ethylene Feedstocks Global
13
U.S. Midstream SectorEvolution Current
Structure
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Evolution of U.S. Midstream Sector
Time Period Rationale Comments
Pre-70s Major Oil Cos. Interstate Pipelines Petrochemical Cos. Main purpose of Midstream was to Bring equity production to market Secure supplies grow rate base Secure fuel feedstock supplies Utility Function Not geared for 3rd parties Unwillingness to sell or rationalize assets
The 80s Emergence of Independents Set up to be Profit driven, discretionary business Serving 3rd parties in major producing regions and/or market centers Price Deregulation of Gas Gas Bubble NGL Demand Growth Margin Price Volatility Customer Relations
Early/Mid 90s Independents Expand Driven to Achieve greater Scope Scale Acquire non-core midstream assets of EPs and Interstates Margins Expand Competition Increases Volatility Intensifies
15
Evolution of U.S. Midstream Sector (2)
Time Period Rationale Comments
Mid/Late 90s Feeding Frenzy Independents acquired by Energy Merchants Regulated Utilities MA driven by need for Scope scale in supply and/or market regions Customer diversity More products services Marketing trading platforms Higher returns Many midstream assets bought at Peak earnings cycle EBITDA multiples of 10 times or more. - Single digit returns - Vulnerable to downturns
By 2000/2001 Some recent acquirers admit failure and exit. Quick turnover of assets Failure to recognize and hedge risks Inability to generate synergies Deteriorating fundamentals Tighter gas market margins Many midstream assets sold at Bottom of earnings cycle EBITDA multiples of 5 to 8 times
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Evolution of U.S. Midstream Sector (3)
Time Period Rationale Comments
Since 2000 MLPs greatly increase presence in Midstream - Independent MLPs - MLPs spun off from Diversified Energies Acquiring fix fee assets (pipelines, fractionators, storage and terminals) from Corporate Parents Majors Distressed Energy Merchants Net income taxed at shareholder level only. MLPs yield 6 -8 distributions with annual growth of 5 -10. Sanctity of distribution very important.
Currently New Entrants - Private Equity Funds Taking advantage of distressed sales Buy low and exit in 5 to 7 years achieving returns of 20 or more. IPO assets into MLP. Not clear if they have a growth plan. Will they repeat the mistakes of previous acquirers?
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Top 10 U.S. Gas Processing Operators (In terms of
NGL Production in MBPD)

• 1. DEFS ----------------
• 2. BP ---------------------
  
• 3. El Paso ---------------
• 4. Williams --------------
• 5. ExxonMobil ----------
• 6. Enterprise ------------
• 7. ONEOK ---------------
• 8. ConocoPhillips ----
• 9. Devon -----------------
• 10. Dynegy ---------------
• Total Prod. -----------
• of US NGLs - Top 5
• of US NGLs - Top 10

• 1. GPM (Phillips) -------
• 2. Amoco -----------------
• 3. Texaco ----------------
• 4. Enron ------------------
• 5. Warren ----------------
• 6. Valero------------------
  
• 7. Conoco-----------------
• 8. Exxon ------------------
• 9. Arco --------------------
  
• 10. Shell --------------------
  
• Total Prod. - - - - - - -
• of US NGLs - Top 5
• of US NGLs - Top 10

1992 157 94 85 84 82 64 64 64 61 59 814 30
49
2001 396 199 158 121 120 75 74 66 62 59 1330
54 72
DEFS - Duke Energy Field Services
ConocoPhillips owns 30 of DEFS
Source Gas Processors Report
18
Current Top Playersof the U.S. NGL Value
Chain(Ranked According to Operating Position in
2001)

Gas Processing 1. DEFS 2. BP 3. El Paso 4.
Williams 5. ExxonMobil 6. Enterprise 7. ONEOK 8.
ConocoPhillips 9. Devon 10. Dynegy
Salt Dome Storage Enterprise TEPPCO
Dow Dynegy Williams ConocoPhillips BP ExxonMobil
Gulfterra ONEOK
Product Distribution Enterprise Dow ConocoPhillip
s TEPPCO Koch KinderMorgan ChevronTexaco Dynegy G
ulfterra ExxonMobil
Raw Mix Pipelines Enterprise TEPPCO Koch ChevronT
exaco Dynegy BP Gufterra ExxonMobil ConocoPhillip
s
Waterborne Terminals Enterprise Dynegy Dow Chevr
onTexaco Trammo
Fractionation Koch Enterprise ConocoPhillips Dyne
gy Gulfterra ExxonMobil BP ONEOK DEFS Williams
In Joint Venture or has Business Alliance with
a Major
Major Integrated Oils and Large EP Companies
Diversified Energy Companies
Publicly Traded MLPs
19
Despite Recent MA Activities, Sector Remains
Fragmented

• Majors and Large EP Companies.
• Focusing on EP offshore and international.
• For many, Midstream is no longer core.
• Energy Merchants or Diversified Energies.
• Repairing balance sheets in many instances.
• In some cases, selling midstream assets or,
• Completing transfer of assets to their MLP.
• Large Independents (MLPs, Joint Venture
  Companies).
• A few are actively growing their midstream
  business.
• Some have business alliances with producers and
  customers.
• However, most MLPs are risk adverse avoiding
  processing.
• Small Independents... niche players.
• Filling regional gaps created by the exit of
  larger players.
• Many, being funded by Private Equity Funds.

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U.S. Midstream Sector Realities, Issues
Challenges
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Current Realities Issues
Price Margin Volatility High Priced Gas Environment A Maturing Gas Resource Base A Sluggish Petrochemical Industry MTBE Phase Out Excess Capacity Not Unique Not Entirely Mutually Exclusive Cause Effect Not all participants affected equally
22
Frac Spread Volatile and Trending Downward
23
Fundamental Shift is occurring in North American
Gas Markets
Gas Bubble Early 80s to Early 90s
Bursting of the Bubble Late 90s to Now
Jan-02
Jan-03
24
On the Supply Side...A Structural Change Could Be
Underway

• Lower 48 basins are maturing with the exception
  of Gulf of Mexico and the Rockies.
• Drilling needs to accelerate to offset natural
  declines from conventional sources.
• Majors focusing on international prospects,
  unconventional plays deep water GOM.
• Many producers less optimistic about accessing
  new additional U.S. sources.
• Many producers limited by leveraged balance
  sheets.

25
On the Demand Side...Industrials must compete
with Electric Generation for Natural Gas
Natural Gas Consumption Electric
8.00
Generation versus Industrial
7.00
Industrial
6.00
5.00
Gas Consumption (TCF/Year)
Electric Generation
Repeal of the
Fuel Use Act
4.00
3.00
Source EIA
2.00
1986
1988
1990
1992
1994
1996
1998
2000
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U.S. Midstream Sector Increasingly Dependent on
the U.S. Petrochemical Industry
US Market Share Demand for NGLs
1974 1984 1994 2002 Petrochemicals
32 36 52 56 Refining
32 25 20 15 Fuel Other
36 39 28 29

• 92 of U.S. ethylene capacity along Gulf Coast
• Over 75 of that capacity directly accesses Mt.
  Belvieu.
• Over 90 of U.S. ethylene capacity connected to
  U.S. NGL
• transportation system
• Almost every ethylene plant accesses salt dome
  NGL storage

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Top 5 Ethylene Producers Control 75 of U.S.
Ethylene Capacity
Ethylene Capacity Market Share

• 1997
• Exxon......... 10.7
• Dow............. 9.6
• Shell............ 8.9
• Phillips......... 8.1
• Millennium... 7.2
• Union Carb.. 7.0
• Lyondell....... 6.8
• OxyChem.... 6.5
• Chevron....... 5.9
• Amoco......... 5.7
• Others......... 23.6

• 2002
• Dow .............. 21.9
• Equistar ......... 18.1
• ExxonMobil... 14.4
• Chv Phillips... 12.0
• Shell............... 8.6
• Formosa......... 5.2
• BP.................. 5.1
• Huntsman........ 4.0
• Others.............10.7

75
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Own Operate Midstream Assets
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A High Priced Gas Environment Could Force the
Ethylene Industry to Minimize Ethane Cracking.
Feedstock Flexibility of US Ethylene Industry
(MBPD)
Swing Vol. as
Swing
Max
Base
Swing Vol. as
Swing
Maximum
Minimum
of US Supply
Volumes
Demand
Demand
of US Supply
Volumes
Demand
Demand
Feedstock
Feedstock
44.5
350
875

525
?
44
350
825
475
Ethane
Ethane
18.6
250
450
200
19
250
450
200
?
Propane
Propane
46.5
150
150
0
46
150
150
0
?
N
-
Butane
N
-
Butane
NA
275
675
350
NA
275
675
350
?
Natl Gaso/
Natl Gaso/
Naphtha's
Naphtha's
NA
230
80
NA
230
80
150
?
Gas Oils
150
Gas Oils
29
(No Transcript)
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U.S. Phase Out of MTBE Will Negatively Impact
U.S. Midstream.

• Reduces need for butanes from US processors by
  15 or about 50 MBPD.
• Shuts down discretionary butane isomerization
  units.
• Forces N-Butane into Petrochemical Feedstock
  Market.
• Puts more competitive pressure on ethane.
• Impact can be mitigated with rapid conversion of
  world-.
• scale MTBE units to Alkylate or Iso-Octane.
• Chances are unlikely rapid conversion will occur
  due to permitting problems and uncertainty of
  returns.
• Some units being permanently dismantled or put
  into deep sleep.

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Average Utilization Rate of U.S. Gas Processors
at Very Low Levels
Oil Gas Journal
32
U.S. Has Surplus Ethane Extraction Capability

• Observations
• 200 MBPD of ethane has
• been rejected in 2003.
• For the past 20 years, US
• Processors built cryogenic
• plants to maximize ethane
• extraction.
• Most processing plants lack
• de-ethanization capabilities,
• making ethane rejection
• inefficient.
• Surplus ethane extraction also
• implies that NGL downstream
• assets are under utilized.

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In Summary Upstream and Downstream Fundamentals
Squeezing U.S. Midstream
High Priced Gas Market
Reduced NGL Demand
U.S. Midstream
Reduces Margins and Volumes Throughout the Value
Chain
34
U.S. Midstream SectorFactors for Success
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The Convergence of a Number of Issues Is
Challenging Midstream Participants To

• Gain a Greater Understanding of Market Dynamics
• Adjust to Low Margins Across the NGL Value Chain
• Minimize Processing Risks Margin Volatility
• Rationalize Underused Capacity
• Achieve Economies of Scale Scope
• Lower Operating Costs
• Upgrade Plants to Reinject Ethane
• Improve Access to Upstream Downstream Drivers
• Repair Balance Sheets, in some cases

36
Key Identify and Manage Profit Drivers Risk
Factors Along the Value Chain
Gas Aggregation
Gas Processing
NGL Transport
NGL Fractionation
NGL Storage
NGL Marketing

• Drilling
• Reserve Life
• Location
• Gas Quality
• Gas Prices
• Power Costs
• Govt Regs
• Competition
• Counter Party
• Risks

• NGL Prices
• Gas Pipeline Specs
• Residue Gas NGL Takeaway Capacity

• Price Liquidity
• Market Demand
• Market Location

37
U.S. Producers and Processors Must Recognize a
Paradigm Shift Is Occurring.
In a Tight BTU Market not all of the Liquids
Extracted by Processing will always receive a
Premium Price to their BTU Value in the Gas
Stream. In a High Priced Gas Environment, having
Rich Gas may reduce rather than enhance the Value
of the Gas Stream.
38
Processing Agreements Must Be Retooled to
Minimize Risks to Independents
High
Risk to Processor
Low
Keep Whole Margin Sharing of Liquids (POL) of Proceeds (POP) Economic Election Processing Fee
Processor keeps extracted NGLs as fee for processing Must purchase and return to producer merchantable gas to replace fuel shrinkage Producer and processor share value delta between NGLs and gas, i.e.. 50/50. Producer gets 100 of wellhead BTUs Processor paid a of NGLs as processing fee. Producer keep their of NGLs in kind or have processor sell NGLs and receive cash. Could have keep whole provisions Processor paid a of NGLs gas as processing fee Producer keep their of NGLs gas in kind or have processor sell NGLs gas and receive cash. Could have keep whole provisions Under uneconomic conditions, producers either bypass plant or pay processor a fee. Fee could be POL or POP or cash Producer pays processor a processing or conditioning fee. Fee is market base and could be POL or POP or cash.
Low
Risk to Producer
High
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Link Leverage the Right Assets to Manage Risks
and Maximize Value --- Avoid Stranded Assets.
Gas Aggregation
Gas Processing
NGL Transport
NGL Fractionation
NGL Storage
NGL Marketing

• Ability to aggregate should
• exceed processing capacity.
• Reserve life should exceed
• the depreciated life of plant.
• Seek production dedications
• Network asset groups.
• Connect to logistics that
• yield highest netback prices.

• Recognize
• NGL markets
• are shifting.
• Market liquidity
• is poor.
• Counter party
• risks exist.

• Diversify NGL supply sources.
• Secure volume dedications
• Have connectivity with highest
• value markets.
• Have sufficient scale to lower
• costs and attract customers.
• Know your competition and
• customers

40
Care Must Be Taken When Forming Midstream Joint
Ventures

• Pros.
• Joint Ventures can
• Increase chances of making a project a reality.
• Distribute monetary burden and risks.
• Pool different resources.
• Diversify sources of supply.
• Provide opportunity to
• Build Critical Mass.
• Achieve Economies of Scale.

• Cons.
• The Dark Side
• Operator is usually in control.
• Decision making is more difficult and cumbersome.
• Conflicts of interest can and often occur.
• Preference rights can hamper a sale.
• Often one party wants to exit or buy out the
  other parties after awhile.

41
U.S. Midstream SectorBusiness Model Future
Ownership
42
Although There Are Challenges, Midstream
Opportunities Will Continue.

• The Midstream Bridge must exist because
• Gas will continue to be the clean fuel of choice.
• N. American gas reserves can support demand
  growth
• LNG bridging supply/demand gaps.
• North Slope and MacKenzie Delta potential
  long-term supply sources.
• 80 of gas produced will need processing or
  conditioning.
• U.S. and Canada have the Worlds largest
  logistics infrastructure to handle NGLs and Gas.
• Petrochemical and Refining Industries remain the
  Worlds largest, but it is imperative that both
  stay healthy.

43
Question Who Can Best Manage the Risks and
Capture the Opportunities in Midstream?
U.S. Midstream at Critical Juncture
?
Midstream Functions
Midstream Profit Centers
- OR -
Back to the Past Business risks so great that
Midstream Activities, particularly Processing,
revert to being functions of the Major
Integrated Oil Companies.
Back to the Future Independents effectively
manage risks, provide value added services and
achieve greater cash flow stability to generate
reasonable returns.

Business Model Needs to Better Balance Risks
Returns Between Independent and Customer
44
The U.S. Midstream Sector Needs Diversified,
Integrated Independents Across the Energy Value
Chain.

• Currently, just a few US companies devoted to NGL
  Midstream as a core business.
• Majors focused on finding and producing Oil
  Gas. Petrochemicals have their own issues to
  resolve.
• Many Diversified Energies still restructuring
  balance sheets.
• Opportunities exist to link complementary and
  strategic NGL Midstream assets that are in a
  holding pattern by current owners.
• But it takes vision, desire, capital, and the
  right approach to profitably grow a midstream
  business
• ..and, the concerted effort of Producers,
  Midstream Players and End Users to insure that an
  Independent business model survives.

45
The Ideal Midstream Player Will Display the
Following Characteristics

• Long-term business alliances with upstream and
  downstream customers.
• Long-term fee-for-service and/or fixed margin
  contracts.
• Ownership in processing in one or more major
  producing regions.
• Access to high capacity gas take-away pipelines.
• Ownership in efficient TF systems to link NGLs
  to major market centers and customers.
• Economies of scale and low cost operations.
• Ability to make selective, synergistic and
  accretive acquisitions.
• Ability to leverage along value chain with
  incremental deals.

Achieve Greater Cash Flow Stability to Compete
for a Broader Range of Opportunities
46
A Word to the Wise

• The more involved a company becomes in the
• U.S. Midstream Sector, the more leveraged its
• profits will be to the health of the U.S.
• Petrochemical Industry.
• A Company with a diversified portfolio of
• (complementary) midstream activities serving
• other energy commodities, offers better income
• stability during times when the Petrochemical
• Industry is in a downturn.

47
More Consolidated U.S. Midstream Sector in the
Future

• Processing sector will be downsized and more
  efficient
• Number of plants will shrink --- smaller,
  marginal plants shutdown.
• Less emphasis on max Ethane recovery plants
  (Cryogenic).
• More of a fee-based service business rather than
  a margin based, discretionary one .
• Value chain ownership will rotate and
  consolidate
• Majors, EPs and Diversified Energies continue
  divesting non-core assets.... only involved in
  Midstream to protect franchise operations.
• Diversified MLPs to be the most active players
  --- dominate TF assets, gradual entry into
  processing as fee-based business develops.
• Small Independents slowly consolidate into
  existing or new MLPs.

48
U.S. Midstream SectorImplications for Canada
49
In Many Respects, Canadian Midstream Is Better
Situated to Handle Challenges

• Canadian Ethylene Industry lacks the feedstock
  switching capability of the U.S. industry, its
  mainly captive to ethane.
• Competition is not with U.S., but foreign
  producers of ethylene.
• Canadian Midstream more dominated by Producers
  than Independents.
• Overall, Canadian Midstream is a more fee-based,
  fixed margin business than its U.S. counterpart.
• Canadian Processors less dependent on cryogenic
  plants with the exception of the large straddle
  plants.
• There are alternative uses for NGLs that are not
  found in U.S.
• Miscible flooding.
• Diluents for heavy crude production and
  transportation.

50
The Transformation of U.S. Midstream Will Have
Limited Impact on the Canadian Sector

• Unlikely to see U.S. companies buying Canadian
  assets as was the case several years ago.
• In fact, companies such as Williams and Dynegy
  are exiting the Canadian Sector as they repair
  their balance sheets.
• Many rushed in too soon to position for
  Northern gas flowing through Western Canada.
• U.S. MLPs are limited in investing in foreign
  assets.
• Although similarities with the U.S. exist, Canada
  must examine the profit drivers and risk factors
  shaping its Midstream industry and adjust
  accordingly.
• Like the U.S., the global competitiveness of the
  Canadian Petrochemical Industry can dramatically
  impact Canadas Midstream Sector.